Blockchain has revolutionised the unregulated cyberworld

Digital ledgers promise less-landmark innovation but benefits aplenty for the regulated world – if aptly used.

AUG 2018
Michael Collins
Investment Specialist

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An international shipment of consumer goods typically comes with about 20 sets of documents, many of which are paper-based and relate to trade finance. About 70% of the information is replicated across the forms. This ‘red tape,’ which costs the freight industry hundreds of millions of dollars each year, has no ‘real time’ visibility to all parties, is prone to errors and is often complex enough to delay payments.[1]

No more, according to an Accenture-led syndicate. The consulting firm this year said it had a distributed-ledger solution that could “revolutionise ocean shipping” because it reduces data entry by 80%, simplifies amendments, streamlines cargo checks, and lowers the risk of compliance breaches.

Some observers said the innovation could be shipping’s biggest breakthrough since the first container ship sailed in 1956. The World Economic Forum says simplifying paperwork and other trade impediments “halfway to global best practices” could increase global trade by 15% and lift world GDP by nearly 5%, a greater boost than trade would receive were tariffs to be abolished.[2]

Such is the promise of decentralised distributed ledgers that sequentially and immutably record and store data in a way whereby people have immediate access to the same information without having to pass through a central point. These ledgers are better known as ‘blockchains’, the software leap from 2009 that enabled the invention of cryptocurrencies.

Notwithstanding that cryptocurrencies are failing to fulfil money’s most central roles (especially to be a store of value),[3] the blockchain rates as a ‘landmark’ invention. Its innovation was that a self-sustaining network under no peak control was created to allow strangers to make and accept payments over the unsupervised internet. And that’s the most apt use of the technology from a technical point of view – and pretty much it’s only widespread use so far.

The distributed-ledger solutions for the regulated world are likely to be less ground-breaking. Nonetheless, ledgers that are destined to be used in the regulated world could enhance productivity across many industries, even if they are not great advances on existing technology. A danger, though, is that these ledgers will create risks, even systemic ones, when used in critical spheres; namely, if they are used to tally general elections and by central banks in the monetary system.

To be sure, future ledger innovations could be leaps akin to blockchain’s development – a big hope is that ledgers can help rehaul and make secure the internet’s protocols, the common agreements that enable devices to interact.[4] Ledgers have this potential because they are considered a ‘foundational’ rather than a ‘disruptive’ technology – one that forms the basis of other milestone advances. But distributed ledgers require networks. The complexities in establishing networks and drawbacks in ledger technology mean the paperwork and multiple data entry that still exit after a generational use of computers are unlikely to find a ‘hey presto’ solution in blockchain form any time soon. Worthwhile ledger solutions might only slowly appear in a regulated world and might only be incremental advances on prevailing technology. That will make them valuable enough in a world in need of productivity growth. But only if their inappropriate use can be limited.

Transformations possible

Bitcoin was created nine years ago to enable ‘peer to peer’ electronic payments by anarchists who were seeking to skirt government control and the financial system.[5] Their challenge was that governments discharge essential functions when they create a currency. One is to prevent counterfeiting. The solution of the libertarians was the counterfeit-proof ‘blockchain’.

The blockchain ensures that Bitcoin is only spent once by adding records to a database shared across a computer network via ‘blocks’ that then become part of the ‘chain’. Each network user has an updated copy of the file, which is why the ledger is called ‘distributed’. Maths formulas called ‘hash codes’ protect each record because to change one record means that all subsequent codes must be updated in chronological order – and that can’t be done unnoticed.[6] Bitcoin’s blockchain is updated by anonymous ‘miners’ who are rewarded for validating the latest batch of transactions in sequential order.[7]

Besides enabling cryptocurrencies, advocates say decentralised ledgers promise to streamline the recording and storage of the contracts that govern much of daily living, especially for online activity. Distributed ledgers are bound to help countries where official record keeping is poor and prone to corruption, especially when clarifying property rights.[8] On financial markets, they will accelerate the transfer of ownership by simultaneously updating the records of all parties on a network.

Decentralised ledgers already exist in the regulated world. Since 2012, Estonia has used the technology for its registries including its national identity card.[9] The University of Nicosia in Cyprus in 2017 issued digital diplomas so they can be authenticated over the internet to help control CV fraud.[10] Ethereum is a decentralised platform founded in 2015 that runs ‘smart’ contracts; the platform automates payments when preset conditions are met and are supposedly immune to deletion, fraud and interference.[11]

More ledgers promise to appear, especially as much money is spent on research. In what is hailed as the “first and largest” government-led blockchain solution, the Hong Kong Monetary Authority (the Chinese region’s de facto central bank) is introducing a digital-ledger trade-finance platform to cut paperwork and reduce fraud.[12] The ASX intends to replace its settlement system with the technology.[13] Taiwan’s HTC is developing a mobile phone that uses blockchain encryption to keep data secure on the phone, not in the cloud.[14] US-based advisory firm, International Data Corp, expects US$2.1 billion to be invested in ledger solutions this year and such spending to reach nearly US$10 billion a year in three years.[15]

Hurdles with genius

The genius of the cryptocurrency blockchain is twofold. The first is that even though they are based on ‘open protocols’ past records can’t easily be altered. The other is that members have a financial incentive to belong even though they have no ownership, as is the case with Bitcoin’s ‘miners’. But these advantages won’t necessarily hold, even for Bitcoin, and ledgers comes with other drawbacks too.

An overarching problem is that ‘permissionless’ pan-national ledgers appear less well suited to areas overseen by national governments and their regulators, especially as privacy gains importance. Distributed ledgers for the regulated world will need to have an entity or person legally responsible, which strips out much of the motive behind the invention of the blockchain.

Another challenge is that a distributed ledger must reach a mass that creates a ‘network effect’ (where each additional user makes a network more valuable for all users). That’s never guaranteed. Industry-wide ledger solutions, for instance, won’t necessarily make sense for all companies in an industry. Some might want to hold a competitive edge in back-office efficiency or keep information private. In shipping, Hyundai Merchant Marine is building a distributed ledger with Samsung to compete against Accenture’s. Shipping might end up with two systems that reduce overall productivity gains.

Other drawbacks include that one party could garner enough computing power to seize control of a distributed ledger (the so-called 51% attack), which would give that party an ability to revise records on the database.[16] Another flaw is that any system based on mutual trust is unstable because trust is fragile and sub-networks can emerge if members disagree on procedures. Bitcoin in January this year splintered 10 ways after members adopted new protocols incompatible with prevailing ones.[17] The shattering of Bitcoin highlights another challenge for such ledgers – how to agree on and maintain common protocols on a bespoke network.

Another problem is that distributed ledgers become permanent records of dodgy data if that’s what they’re fed. They appear as vulnerable to cyberfraud as any other technology, even if Bitcoin’s blockchain has proved secure. Many people are wary of using them because any indiscretions paid for over the technology can be discovered.

If Bitcoin’s blockchain is any guide, ledgers will consume huge amounts of energy, which saps their cost advantages. The Bank of International Settlements estimates the Bitcoin blockchain uses as much power as Switzerland, where it is based, “such that the quest for decentralised trust has quickly become an environmental disaster”.[18]

These ledgers confront the paradox that they rely on the network effect to succeed yet are subject to a network limit. The technology lacks ‘economies of scale’ in two ways. The first is the speed at which records can be added to the chain is fixed at any point. The other flaw is that the requirement that users download and verify all past transactions becomes more cumbersome as use rises.

Swift, the Belgium-based group that handles payments between 11,000 financial institutions in more than 200 countries, said in March its testing showed that “more progress needs to be made” before ledger technology is capable of handling the billions of dollars of daily interbank payments between banks.[19] The Bank of International Settlements warns that everyday use of Bitcoins “could bring the internet to a halt”.[20] Such inadequacies raise the question of why use the technology when prevailing solutions aptly handle hundreds of millions of transactions at any one time anyway.

Neo-mania traps

Nassim Taleb in his book Anti-fragile used the term “neo-mania” to describe when people prefer new technology just because it is new even though the incumbent technology is adequate and has stood ‘the test of time’.[21] Distributed ledgers present this trap, possibly to great risk. Two possible misapplications stand out.

The first is the technology’s use in elections to replace secret paper-based voting that dates from the mid-1800s[22] (or as a substitute for electronic voting, first used by Estonia in 2005, which shares many of the same flaws as ledger voting). In March, Sierra Leone became the first country to use blockchain technology for a general election when Swiss startup Agora verified the result of one region in the African country’s presidential poll.[23] In the first such use in the US, Voatz has pioneered out-of-state military voting in West Virginia elections,[24] while recognising questions to be addressed include “end-to-end verification, voter anonymity, authentication, security, cost, ease of deployment, scalability, user experience and most importantly public trust”.[25]

Notwithstanding that no controversies emerged in these two episodes of ledger-based voting, public trust will likely remain an unachievable goal because the integrity of elections can never be guaranteed when there are no ballot papers to recount. Any blockchain system would be vulnerable to a ‘51% attack’ – and governments have the resources to conduct these attacks. People who forget their password would miss out on voting. While a forgotten password system would overcome this drawback, it would introduce security vulnerabilities because voter devices could be hacked.[26] The assumed benefits of the technology – presumably lower cost, reduced risk of vote tampering, faster results, fewer disputed voting marks, fewer lost ballot boxes, and perhaps higher turnout (set against onerous authentication procedures) – must be weighed against the risk of civil unrest or worse if elections handled via digital ledgers are contested and the outcome remains disputed.

The other neo-mania involves calls for central banks to issue digital fiat money to the public to gain total control of the money supply and improve the payments system.[27] The biggest risk is that it would eradicate the four-centuries-old fractional-reserve banking system because banks would no longer receive deposits on which they base their lending.[28] The question then would be which institutions would conduct the lending that is the lifeblood of capitalism. Those against central banks issuing digital coins say such a system would be akin to how in the Soviet Union the monetary authority called Gosbank was the only bank.[29] A second concern is that commercial banks might be more prone to bank runs if people could divert their money to a central bank. Central banks, more immune to neo-mania than most institutions, are in no rush to adopt the technology, though those in Sweden[30] and Uruguay[31] are considering testing digital ‘base’ money.

As with most tech advances, only time will tell if distributed-ledger technology provides vast net benefits for society, even if it looks like magic right now for shipping.

By Michael Collins, Investment Specialist

How blockchain works

Source: Financial Times

[1] Accenture. ‘Industry consortium successfully tests blockchain solution developed by Accenture that could revolutionise ocean shipping.’ 14 March 2018. Other companies in the syndicate included APL, which owned by the world’s third-largest container line CMA CGM, Anheuser-Busch InBev and Kuehne + Nagel. newsroom.accenture.com/news/industry-consortium-successfully-tests-blockchain-solution-developed-by-accenture-that-could-revolutionize-ocean-shipping.htm

[2] World Economic Forum. ‘Enabling trade: Increasing the potential of trade reforms.’ See introduction that says eradicating tariffs would only boost exports by 10% and world GDP by 0.7%. 2016. reports.weforum.org/enabling-trade-increasing-the-potential-of-trade-reforms/?doing_wp_cron=1528958024.3605060577392578125000

[10] To learn more, go to: University of Nicosia. ‘Academic certificates on the blockchain.’ digitalcurrency.unic.ac.cy/free-introductory-mooc/self-verifiable-certificates-on-the-bitcoin-blockchain/academic-certificates-on-the-blockchain/

[22] Australia was one of the first countries to use paper-based voting, first using it in 1856. National Museum Australia. ‘Defining moments in Australian history. Secret ballot introduced.’ nma.gov.au/online_features/defining_moments/featured/secret_ballot_introduced

[26] To learn more about blockchain-based voting, see: Team Plymouth Pioneers – Plymouth University. ‘Digital voting with the use of blockchain technology.’ Undated but no earlier than 2016. economist.com/sites/default/files/plymouth.pdf

[27] For once such call, see: Financial Times. ‘Central banks are right to consider the merits of digital cash.’ 18 March 2018. ft.com/content/2fb50f4e-2842-11e8-9274-2b13fccdc744?emailId=5aab97ba6233e20004129c98&segmentId=7d033110-c776-45bf-e9f2-7c3a03d2dd26

[28] Historian Niall Ferguson in his ‘The ascent of money: A financial history of the world’, says fractional-reserve banking was invented by Stockholms Banco in Sweden in 1657. Penguin. 2008. Page 50.

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